Selecting a Business Organization Format
In our case study, Jackson, Maria and Jessica all hope their new business (to be referred to as JMJ for convenience) will be profitable, but what if it loses money rather than generating a profit? JMJ will need to be set up to protect their personal assets. They will also have to decide how they wish to handle taxes. If they wish to have a corporation-like tax system, LLCs are state-level designations (for tax purposes), but they can choose whether to be taxed like a partnership (i.e., an unincorporated business) or a corporation at the federal level instead. Since you set up your business in the state you conduct most of your business activities (or, if nation-wide, where your headquarters are located physically), it may depend on which state you live in when deciding how to set up taxation guidelines for your LLC. Some states have noticeably “business-friendly” taxation laws (like Delaware and Nevada (Perez, 2009)) and nation-wide businesses can choose to incorporate there as well as in their home state. If Jackson, Maria and Jessica think they will prefer to handle taxes as “pass-through entities” (Andrade, n.d.), then a LLC set up to be taxed at a shareholder or member level (an LLC-partnership), a LP, or a LLP might be a wiser choice.
If a business is profitable, it should consider choosing the LLC-corporation format, where taxes are paid federally. If a business is just starting out or might lose money before turning a profit, then choosing a system which distributes profit (or loss) among shareholders or members may be wiser, in which case LLC-partnerships, LPs, or LLPs should be considered, as members pay their share of taxes individually while being protected from any personal asset forfeiture or legal problems if the business as an entity experiences difficulties (and limited partners–who contribute financially but not in any business decision-making processes–won’t be forced to pay a self-employment tax, which can be expensive). When the business becomes reliably profitable and shareholders or members start to risk being bumped up into a higher tax bracket, it is acceptable to change your form of business, and selecting (as an example) a LLC-corporation at this point can shield individuals from higher tax payments.
JMJ also will have to decide how they intend to conduct business. Jackson and Maria clearly intend to take more active roles in shaping and promoting JMJ, whereas Jessica wishes to finance the venture but does not feel like her skills will benefit JMJ. Jackson and Maria will prefer to operate as general partners (if JMJ were a realty, Maria could not be both a salesperson (a real estate broker) and a general partner (Joint Committee on Administrative Rules, n.d.), but JMJ is not selling real estate), while Jessica may feel more comfortable (and more protected from personal liability) as a limited partner who contributes funding but does not take an active part in managing or making decisions for the business.
LLPs are typically restricted to legal partnerships between people offering specific services that also typically require the practitioner to be licensed. LLP registrations must be renewed annually (Tufts, 1998). Architects, physicians, dentists, lawyers, and other similar professionals may choose to partner with other professionals in their field, usually while sharing office space and a physical business address. In LLPs, each partner has some personal liability protection, so if, for example, several psychiatrists have formed an LLP and share office space and one is sued, the other psychiatrists in the LLP are not considered legally responsible (unless one was in a supervisory position over the one which was sued; but they may be held financially responsible as partners if the business can’t repay its debts or they may have to contribute to the cost of a sued partner’s lawsuit). Profits from LLPs are also taxed individually (treated like personal income), and not like corporations. Some states do not recognize LLPs, and LLPs are dissolved if one partner dies, retires or leaves, which requires debts and assets to be distributed (if there is not a prior business agreement in place that would allow the other partners to buy the departing partner out) and then the remaining partners have to form a new LLP or consider a different business organization. Since JMJ will not be formed by a group of people with licenses to perform the same professional services, we aren’t told whether their state recognizes LLPs, and since Jackson, Maria and Jessica are not going to be involved in exactly similar ways in the business, a LLP probably does not suit their purpose (Brown, 2012).
LPs are partnerships which require at least one general partner and at least one limited partner, are “typically used for asset protection purposes or for family estate planning and gifting purposes (to avoid estate taxes),” and may require setting up a “shell company” to act as a general partner to protect assets and avoid some taxation (Twomey, 2011). LPs require at least one general manager to handle the business, and this person or people bear the brunt of any liability or business-related debts. JMJ technically qualifies, as it would have two general partners – Jackson and Maria — managing the business’ professional decisions and its activities, and one – Jessica — choosing to limit her contributions to investing capital into the business. Jessica’s personal risk would therefore be limited to possibly losing some or all of her invested funds, but she would be protected from incurring any of JMJ’s business-related debts or dealing with any potential legal problems with which JMJ (as a business entity) might become involved (unless Jessica herself performs a negligent act ostensibly on behalf of JMJ).
LLCs have to include “LLC” in the business’ legal name and clarify in their Articles of Organization (similar to a corporation’s Bylaws, and these legal documents are required to be properly filed with the correct department, usually the Secretary of State: an oral agreement alone is not legally sufficient to form a LLC, even though an oral agreement is considered sufficient for setting up the LLC’s management structure or its operating agreement (Twomey, 2012)) whether its business will be handled by managers or members. Managers (like general partners) act like a Board of Directors, but members (like limited partners) act like shareholders or investors. Some states have restrictions on which occupations are allowed to form LLC businesses (Murillo, 2012); JMJ would be operating like a typical for-profit start-up, however, and shouldn’t run into an occupational-restriction barrier to forming a LLC. People who form LLCs typically are not held personally liable for the LLC’s debts or legal issues as long as they were up front about their relationship to the LLC and acted in good faith: no one is liable beyond their investments or equity in an LLC, and everyone’s personal property and other assets are protected. Members of LLCs, like Jessica, can defer to managers, like Jackson and Maria, to act as authorities on behalf of JMJ (Twomey, 2012).
Jackson, Maria and Jessica should probably consider forming a LLC-partnership, with the option to shift into a LLC-corporation for tax purposes once JMJ turns profits regularly. Jessica can protect herself while still contributing money from her inheritance, and Jackson and Maria can take more active roles in the company as general partners.
Twomey, D. P., and Jennings, M. M. (2011) Anderson’s Business Law and the Legal Environment. Retrieved from http://digitalbookshelf.southuniversity.edu
Perez, W. (2009, June 12). Protect Your Business Profits by Incorporating: Choosing the Best Form of Business for Your Needs. Retrieved from http://taxes.about.com/od/taxplanning/a/incorporating.htm
Murillo, V (The Houston Chronicle). (2012). Business Models & Organizational Structure. Retrieved from http://smallbusiness.chron.com/limited-liability-partnerships/
Andrade, H (Texas Secretary of State). (n.d.). Selecting a Business Structure. Retrieved from http://www.sos.state.tx.us/corp/businessstructure.shtml
Brown, K (Oregon Secretary of State). (2012). Select Your Business Name and Structure. Retrieved from http://filinginoregon.com/pages/business_registry/info_center/bus_resources/steps_starting/busname_structure.html
Tufts, R. A. (1998). Choosing a Business Structure to Limit Liability (Originally published in Highlights Of Agricultural Research, Volume 45 Number 1, Spring 1998). Retrieved from http://www.aaes.auburn.edu/comm/pubs/highlightsonline/spring98/liability.html
Secretary of State Information / South Carolina Is Open For Business. (2011, February 2). Difference between a “limited partnership,” a “limited liability partnership,” and a “limited liability company?” Retrieved from http://www.scsoscom.com/?p=911
Joint Committee on Administrative Rules. (n.d.). Administrative Code (TITLE 68: PROFESSIONS AND OCCUPATIONS / CHAPTER VIII: DEPARTMENT OF FINANCIAL AND PROFESSIONAL REGULATION / SUBCHAPTER b: PROFESSIONS AND OCCUPATIONS / PART 1450 REAL ESTATE LICENSE ACT OF 2000 / SECTION 1450.600 CORPORATIONS, LIMITED LIABILITY COMPANIES, PARTNERSHIPS AND LIMITED PARTNERSHIPS). Retrieved from http://www.ilga.gov/commission/jcar/admincode/068/068014500F06000R.html